AUD/USD 2007 First Quarter Outlook
Will High Yields Continue to Boost AUD?
Risks to Carry Trades through 2007: Will High Yields Continue to Boost AUD?
With interest rates the second highest of any country that has a top S&P sovereign rating, Australia has been the very clear recipient of foreign funds seeking the highest returns to capital. This has led to tremendous carry trade interest, with traders selling lower-yielding currencies such as the Swiss Franc or Japanese Yen to buy the Aussie dollar. Subsequent pressures on overall currency valuation are undeniable, with the AUDJPY currency pair at its highest levels since 1997.
Interest rates remain the name of the game in the outlook for the Aussie dollar, with any shifts likely to cause shifts in exchange rates across the board. This leaves the currency particularly vulnerable against the low-yielding Swiss Franc and Japanese Yen, with the prospects of lower yield spreads to place downside risks on further Aussie dollar gains. The timing of such falling spreads remains key, however, which suggests that a continued hawkish bias will leave the Australian dollar bid through the short term. In fact, speculation of a further Reserve Bank of Australia interest rate hike through February may underpin the domestic currency through the coming months.
RBA to Remain at 6.25%? Synthetic Forwards Show Possibility of Another 25bp through H1 2007
Markets have recently been at odds with each other on whether to expect higher Australian interest rates through 2007. Looking at domestic bond prices, an inverted yield curve shows clear expectations of moderating interest rates within the medium to long term. At the time of writing, the 10-year Australian Government Bond was yielding 18 basis points less than the 2-year issue. Looking to synthetic interest rate forward rates, however, traders are still pricing in a small possibility of a further RBA hike through the first quarter of 2007. Whether or not this comes to bare will depend on a number of countervailing forces.
Wage Growth Challenges Outlook of Stabilizing Inflation
Given three RBA rate hikes on the year and clear signs of slowing growth, Reserve Bank officials have forecasted moderating price pressures through 2007. In fact, their November statement shows that, taking their most recent rate increase into account, price growth should fall below the top end of their target range through Q2, 2007. A moderation in imported energy costs and gradual easing of global inflation should help contain prices, while a recovery in labor productivity should expand capacity and contain wage growth. Highlighted risks to this outlook remain, however, if the slowdown in wage pressures does not materialize.
One of the clearest drivers of Australian inflation has been stellar labor expansion, showing unemployment rates now at 30-year lows of 4.6 percent. Such tight labor conditions have put strong pressures on overall wage levels, with the Wage Price Index showing 4.1 percent year-on-year growth through the most recent quarter. As one of the primary drivers of inflation, strong Australian WPI gains undoubtedly place risks to the upside for headline CPI changes. Overall consumer price inflation remains well above the RBA's target range of 2-3 percent at 3.9 through Q3, 2006. Going by wages alone, we could easily see the central bank raise their target interest rate by 25 basis points at their February meeting. As their November Statement on Monetary Policy suggests, however, there remain counteracting forces that may leave risks to the downside for the headline inflation rate. This places tremendous pressure on fourth quarter CPI data, due through the third week of January. Any surprises could certainly affect currency prices, with the outcome from the February RBA meeting in the balance. Otherwise, traders will look to other areas of previous economic strength.
The Future of Domestic Economic Growth: Can Australia Repeat Previous Capital Expenditure-led Strength?
As one of the world's foremost producers of a number of key industrial commodities, Australia has benefited greatly from surge in raw materials of the past few years. The extended rally has left producer profits significantly higher, with the influx in capital leading to a similar gain in domestic investment. Given that this appreciation was primarily due to above-trend global growth, however, a broader slowdown threatens to leave commodity prices relatively unchanged through the coming year. For this reason, it is increasingly likely that domestic investment will slow, potentially leading to a retrace in incredibly strong labor growth and a normalization of wage pressures. This would have two-fold effects on the domestic currency. Of primary considerations, softer GDP expansion and slower price gains would in of themselves lead to a fall in optimism for the Aussie dollar. In addition, a slowdown in commodity purchases would also affect the domestic trade balance of goods and services. Needless to say, currency traders will have to monitor future developments in commodity markets and their effects on the economy through the coming year.
The National Drought: Can the Economy Continue to Grow Despite Falling Agricultural Production?
Many economists have recently cited a national drought as a primary downside risk to growth in 2007. Looking closely at overall figures, we may indeed see downside risks to GDP growth, but the extent to which the broader economy will decline is yet unclear. According to the RBA, farm output accounted for a total of 3 percent of aggregate Australian economic production. Predictions of a 20 percent drop in Farm production thus directly translates into about ½ percentage points off of national GDP. Likewise significant, RBA officials claim that a trickle-down slowing of consumption could cost the domestic economy another ¼ percentage point of GDP - bringing the headline figure a total of 0.75 percent lower on the year. What remains to be seen is if government assistance programs in place will indeed help to mitigate negative effects and partially offset an otherwise dour outlook on the drought's effects on GDP. Indeed, we must look to key economic figures to gauge the net effects, but risks may be overstated if other sectors of the economy are able to withstand the downward pressures.
Conclusion: AUD To Continue to Enjoy Yield Benefits, but Risks to Growth Remain to the Downside with Drought and Potential for Broader Global Slowdown
Inflation and wage data will dominate the ledger for the Australian dollar through the first quarter of the year, as traders continue to speculate on the future of domestic interest rates. With synthetic forwards pricing in an approximately 40 percent chance of an RBA rate hike through March, the Aussie could indeed see further appreciation on widening yield spreads. Of course, such an outcome will depend heavily on whether inflation stays above the RBA's 2-3 percent comfort zone. Risks to the upside include strong labor growth and food prices, while the threat of slowing global growth and high borrowing costs could limit inflationary pressures through the medium term. With the Australian Bureau of Statistics set to release quarterly CPI figures in the third week of January, we could see considerable Aussie volatility through the beginning of Q1, 2007.
Technical Outlook
The symmetrical triangle that began on 2/20/2004 remains intact. Triangles are often 5 (a-b-c-d-e) waves and this triangle has completed 4 waves. The current wave would be the fifth and thus the favored view is that AUD/USD is heading towards the supporting trendline from the triangle. As mentioned in the USDCHF, alternating legs of triangles are often related by a Fibonacci ratio. A decline from the recent high at .7929 would equal 61.8% of the C leg at .7327. This is close to weekly lows made in June. Resistance is the mentioned .7929 along with the 2004 high at .8003. Following the completion of wave E within the triangle, the AUDUSD could break out and resume its long term uptrend.
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